Not Made in China

By
Scott Reamer, CIO, Rotella ChoraMay 11, 2007 3:16 pm

China's latest export to American consumers and their domesticated pets - a renal failure-inducing concoction of melamine and cyanuric acid - is not exactly what free traders had in mind when they speak of the 'fruits of globalization.'

Stay Connected

China's latest export to American consumers and their domesticated pets – a renal failure-inducing concoction of melamine and cyanuric acid – is not exactly what free traders had in mind when they speak of the 'fruits of globalization.'

Incented by a heady mix of profit motive, regulatory vacuum, total lack of market feedback, and a blithely gullible consumer, those neo-capitalist wheat gluten kings of Jiangsu province opted for coal firing scrapes rather than actual protein to add to their err…additive.

The knee jerk reaction to the kidney failure of pets and God-knows-what impact on the human food chain (try to find a processed food on a supermarket shelf with more than four ingredients that doesn't contain wheat gluten) has been and increasingly will be obvious: indict the whole dirty capitalist structure. Such a response has its emotional fountainhead to be sure, but surprisingly it also has an intellectual one.

Economic theories – at least the ones that have survived the test of time and use – suggests that the process of disintermediation of an industry value chain is the inevitable result of increased productivity and capital efficiency. Imagine a hypothetical General Motors (GM) where the company owns and operates all the businesses one would need to create an automobile: commodity businesses, steel plants, fabrication facilities, trucking/transportation/logistics assets, assembly, distribution, retail car sales dealerships, automobile mechanic garages, and parts manufacturing and selling (not to mention insurance provision, gas/oil sales, etc). You get the point.

Such an enterprise would be massively inefficient and would, of course, never succeed. The process whereby those 'non-core' components of automobile manufacturing are spun off is disintermediation. Shedding those lines of business to firms who operate such businesses with greater capital and labor efficiency saves GM money and provides a better product to employ in its manufacture of cars. A win-win for all involved.

Disintermediation, in and of itself, is a natural and highly important evolution of all industries. Globalization writ large – the export of manufacturing to low cost producers in China and India - is in fact a proper economic calculation on GM's part should those manufacturers produce a product as good or better for lower all-in cost. Nothing wrong there according to the tenets of maximizing utility.

But that disintermediation process can be distorted by government involvement in the disintermediation process. It can be perverted by the Fed's efforts to control the price of money.

When a management team and board of directors make the decision to shut down a manufacturing plant here in the US and either build one in China or outsource the production of said goods to a separate business in China, they do so based on the relevant calculations of return. They attempt to make the best use of their labor and their capital as well as determine the future of end demand.

The cost of money affects all of the above: end demand, labor productivity, and capital returns. All else being equal, a low cost of capital incents companies to expand their fixed capital infrastructure and incents consumers of said products to consume them in greater quantities than they otherwise would. We have seen just this process over the last several years: consumers have been incented to go into debt for the consumption of consumer goods while manufacturers writ large have been incented to outsource (disintermediate) their businesses to take advantage of cheap labor costs in China.

Thus, an artificially low cost of capital perverts the normal market feedback mechanism inherent in capitalist systems: consumers over-consume and manufacturers over-produce. This creates the glut of products that inevitably become malinvestments and thus the whole boom-bust process comes into existence.

But that over-consumption and over-production are not without non-economic costs. Kidney failure of domesticated animals being one of them.

In the rush for consumers to over-consume and the over-production of consumer goods that follows by manufacturers who significantly intensify their industry disintermediation plans, the entire process of outsourcing is distorted. This distortion creates precisely the types of corner cutting and profit maximization that we are witnessing among Chinese wheat gluten manufacturers.

It isn't then the system of profit-seeking capitalists that is to blame for the poisoning of perhaps a non-trivial part of the US food chain. They are, after all, seeking to do just that – maximize profits within the auspices of a mature property rights and legal precedent-based judicial system (which is not the way one would describe China).

In the final analysis, when you can create money out of thin air, you create the kind of incentives that produce altogether too-aggressive consumption, vastly greater rates of outsourcing, and far less regulatory oversight.

When you mess with the price of money as the Federal Reserve has done in egregious ways over these last several years (and by last several I mean the last 94), then pet dialysis is the type of unintended consequence you can expect.

The informatio=
n on this website solely reflects the analysis of or opinion about the perf=
ormance of securities and financial markets by the writers whose articles a=
ppear on the site. The views expressed by the writers are not necessarily t=
he views of Minyanville Media, Inc. or members of its management. Nothing c=
ontained on the website is intended to constitute a recommendation or advic=
e addressed to an individual investor or category of investors to purchase,=
sell or hold any security, or to take any action with respect to the prosp=
ective movement of the securities markets or to solicit the purchase or sal=
e of any security. Any investment decisions must be made by the reader eith=
er individually or in consultation with his or her investment professional.=
Minyanville writers and staff may trade or hold positions in securities th=
at are discussed in articles appearing on the website. Writers of articles =
are required to disclose whether they have a position in any stock or fund =
discussed in an article, but are not permitted to disclose the size or dire=
ction of the position. Nothing on this website is intended to solicit busin=
ess of any kind for a writer's business or fund. Minyanville management=
and staff as well as contributing writers will not respond to emails or ot=
her communications requesting investment advice.